Valuable Strategies

A contrarian approach can be as simple as the technical observations of price swings made in a swing trading or day trading strategy, or far more complicated based on volatility indexing or trends in options trading.

The swing approach relies on charting patterns. The most popular among these are the short-term trend, narrow-range day, and volume spike. When these occur along with a clear reversal day, the swing trader defies the popular sentiment and makes a contrarian move. Swing traders are the ultimate technical contrarians.

Measuring volatility is a method preferred by traders who have observed a correlation between market trends and options trading.

The Chicago Board Options Exchange Volatility Index (VIX) has been used since 1993 to measure market volatility. It is based on trends in the implied volatility of options on stocks in the S&P 500 index.

The VIX is a predictive index often called the 'fear index' because it measures market uncertainty. High implied volatility is viewed as a measurement of traders' fears about marketwide trends and the potential for increased risk over the next 30 days.

VIX valuation is derived from weighted price blending for a range of options on stocks of the S&P 500. However, in addition to serving as a measurement of current volatility, the VIX has also become a speculative market instrument in its own right. As of 2006, VIX options contracts were first traded directly; these are literally options on an index tracking options volatility. The VIX also is traded in the futures market and as an ETF that tracks futures performance levels. As a result, traders can speculate on increases or decreases in market risk based on changes in the implied volatility of options.

Before the VIX, an older volatility index, the VXO, was used. This was a calculation of 30-day implied volatility, but only for at-the-money options (the condition when the strike price is identical to market value of the underlying stock).

Because volatility is one of the important elements used to calculate overall premium value of options, using options to measure market volatility makes sense. The broad options market has become an important market indicator as a result. While a segment of the investing and trading world continues to think of options as highly speculative, intangible 'side bets' on the market and on direction of price movement, they provide more valuable functions as well. Contrarians with advanced knowledge and experience are likely to track VIX to help time and confirm other indicators to time entry and exit.

Key Point

The VIX is called the 'fear index' because it measures not the volatility of the market, but the perception of volatility.

Contrarians are aware of the significance of VIX as a 'fear index' that can provide valuable insight. Many people view VIX as a specific measurement of volatility, thinking that a high VIX level translates to a bearish stock market. However, this is not the case. A high VIX measures the fear of volatility, which can mean the market is perceived as volatile in either a bullish or bearish direction. This distinction is important. The activity in the speculative side of the options market is quantified within the VIX, and this is translated to a percentage value. It is not just the percentage that conclusively determines volatility, but the change in the VIX percentage over time. As the percentage rises, it means the perception of volatility is rising as well. It measures how options traders perceive the market by how willing they are to trade in options over the next 30 days. Likewise, when traders think the risk levels are low, the VIX will fall to reflect that perception.

Contrarians are not limited to the VIX to time their trading decisions. They use a variety of measurements. Among these is a strategy called dogs of the Dow. The theory underlying this is that investors tend to pick the 10 DJIA stocks whose dividend is the highest percentage of the current price per share. The theory states that companies offering the highest dividend levels are likely to outperform the overall DJIA stock index.

The dogs of the Dow is so called because higher dividend yield is likely to result from a decline in market price of shares. This occurs because dividends are fixed for the current year even while stock prices move. So when a company's stock price loses value, the dividend yield increases. For example, consider what happens to a company that started the year with shares at $50, and declaring a dividend of $1.00 per share. What happens when the stock price falls to $40 per share, or to $30?

Price per Share

Dividend

Dividend Yield

$50

$1.00

2.0%

$45

$1.00

2.2%

$40

$1.00

2.5%

$35

$1.00

2.8%

$30

$1.00

3.3%

The lower the price, the higher the yield. According to the contrarian model, the 10 Dow stocks with the highest yield are also most likely to be at the bottom of their price cycle. If this does truly identify stocks that are oversold, it makes sense to go long in the dogs of the Dow. In addition to the benefit of buying at the bottom of the price cycle, the contrarian using this method also gets a higher-than-average dividend yield. In the example above, the stock at $30 per share yields 3.3 percent, but when the same stock was at $50, dividend yield was only 2.0 percent.

Key Point

Declining stock prices result in higher dividend yield, making a depressed stock more profitable on the dividend side. For contrarians, this can also be used to find bargain-priced stocks.

To critics of the theory, the highest-yielding stocks may also be the most distressed among the 30 industrials. However, the distressed situation may refer only to a price cycle and not necessarily to an economic or business cycle. Because of this, a contrarian may use the dogs as one of several indicators pointing to smart timing, but also check other indicators to avoid buying shares in companies losing their value investment status as well. The dogs of the Dow is also useful in timing of sales. As prices rise and stocks are no longer in the grouping of 10 stocks, it can signal the time to sell. For contrarians, this means selling shares after prices have risen, clearly a contrarian move. At such times, it is more likely that traders will be buying up shares based on strong upward movement.

These 10 stocks are called 'dogs' because the bargain pricing and attractive dividend yield appear when the stocks are out of favor. And so contrarians move in and buy at that moment. When the market once again likes those companies (meaning they are no longer dogs), the contrarian takes the change as a sell signal.

By Michael C. Thomsett

Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.